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July 1, 2022

How to Calculate your Net Profit (Example and Formula included)

How to Calculate your Net Profit (Example and Formula included)

Calculating finances is always a tricky part of running your business. There's a lot of technical knowledge required, and it's challenging to work out the definitions of everything. You should keep on top of your company's gross profit, calculate your marketing budget, ensure you know when the accounting period is, and work out revenue and net profit. 

If you're not good at math, it's hard to know where to start. Never mind understanding the definition of all these financial terms. 

Getting a firm idea of your company's financial performance is crucial to the ongoing success of your business. You need to ensure every product you sell generates profit for the business. But calculating net profit is also vital to understanding your operating expenses and allows you to make an informed decision about your brand's budget. 

This article will tell you everything you need to know about net income, profit margin, gross income, and how to calculate net profit and net profit margins to help you understand your company's financial health. 

Definitions for Standard Financial Terms

First, before we get into the formulas and calculations, let's define the terms we'll be referring to in the rest of the article, so you know what we're talking about. This can be a valuable tool to refer to if the financial terms are confusing for you to remember, especially if you're just starting your business. 

Ultimately these formulas and calculations help you work out your company's profitability, so you can try to improve net profit and work out where your company's profits are coming from. 

Gross Profit

Gross profit can also be referred to as operating profit or operating income. Gross profit is how much a company's profits are after subtracting how much it costs to manufacture and ship the products (commonly called the Cost of Goods Sold or COGS). 

It's an excellent way to calculate how efficiently your business produces your products and measure ongoing expenses like labor and manufacturing. 

The gross profit formula is revenue minus cost.

Gross Profit = Revenue - Cost of Goods Sold

Cost of Goods Sold (COGS)

The cost of goods sold, as mentioned above, refers to the direct costs involved in selling products. Such as the total expenses behind manufacturing and selling the products. It can be related to several variable expenses like: 

  • Raw materials
  • Production staff wages
  • Production machinery costs
  • Shipping expenses
  • Overheads and utilities
  • Repairing equipment expenses

COGS is generally made up of variable expenses that could change at any time. Wages rise, a machine could break down and require an expensive repair, or rent at the warehouse could go up. Several other expenses can qualify as COGS. 

Typically, you would break down these business expenses into each product. For example, if you pay $1500 per month for a warehouse rental, you wouldn't be subtracting total expenses from each product. You'd divide it among products sold. 

Let's say you sold 670 products and paid $1500 in rent. You divide the 1500 by 670 and apply a $2.23 COGS to each product for the rental payment. 

But you'd need to factor in the other expenses too. Say staffing costs were $3000 each month. 3000 divided by 670 is $4.47, so that would also have to be factored into the cost of goods sold. 

Revenue

Revenue refers to the amount of money a company generates from selling products. It's often called the top line because it's the high figure which doesn't account for any business expenses. 

For most companies, revenue is generated through selling products or services that people pay for. Let's say you have a product that costs $25, and you sold 389 of them this month. Your revenue for the month would be $9,725. 

That's the top figure you'll then subtract all the business expenses from to calculate net income and net profit margins. 

Expenses

Put simply, an expense is when you have to pay for something to generate revenue for your business. It includes direct costs like operating costs, payments to suppliers, staff wages, or rental charges for factories or warehouses. 

When completing your income tax returns, many company expenses can be put on your tax return, allowing you to write off these tax-deductible costs. Still, the Inland Revenue Service (IRS) is particular about which costs can be included. 

Generally, expenses can be divided up into two categories. First, there are operating expenses which refer to the direct costs involved in creating and selling your products, like the cost of goods sold, wages, and rent. Secondly, there are non-operating expenses which are costs you incur that are not directly related to the business's core operations. These could be interest expenses for taking out loans. 

Net Income

Net income and net profit are the same, so we will use the terms interchangeably. Net income is the amount of company profit earned in that accounting period. It's also called the bottom line because it's the final number where you can work out how much profit each product gets you. 

A company's net income is calculated by subtracting all costs incurred by your company, so you can work out how much each product generates in profit. This helps you work out which products are the most profitable. Calculating a company's net profit is also helpful to measure your company's financial health, and investors will look at it when deciding whether or not to invest in your business. 

Expenses you'll consider when calculating net income include: 

  • Operating costs
  • Marketing expenses
  • Total staff wages
  • Taxes
  • Shipping costs
  • Overhead costs like utilities and rent/mortgage payments
  • Office expenses
  • Machinery and production costs
  • Raw materials
  • Packaging
  • Repair costs for manufacturing
  • Employee benefits like PTO and sick days

When considering net income, you look at both fixed and variable costs. Every expense incurred by your company goes into this calculation. 

What's The Difference Between Gross Profit and Net Profit?

Gross profit refers to the total amount of profit you generate without considering indirect costs to the business like all staff salaries, website maintenance costs, marketing, and advertising expenses. Whereas net profit helps you calculate the bottom line of how much each product generates in profit. 

The gross profit is still a useful number, but net profit tells you exactly how much you earn per product when considering all the additional expenses your company has. If your net profit is relatively low, you can decide whether or not it's worth selling that product. 

Why is Net Profit Important?

Net profit is a crucial financial metric for you to understand as a business owner. You always want to ensure you have a positive net income. 

A company can still generate revenue and have a negative net income if the costs to create the products are higher than the profit earned. If you end up in this position, you're losing money, and you'll need to take measures to improve net profit, like cutting down on operating costs or labor. 

Based on what your net profit tells you, you can decide to re-evaluate your business model and adjust things. It gives investors a metric to measure you against too. 

How To Calculate Net Profit

The formula used to calculate net profit is simple. You'll look at total revenue and subtract total expenses from the top number. 

Net Profit/Net Income = Total Revenue - Total Costs

For example, let's say your company has generated $56,000 in revenue in the last quarter from all your product sales. But your business expenses have been a total of $45,000 in utilities, manufacturing, shipping, wages, and machinery for the same time period. 

That gives you a total net profit of $11,000 for the quarter. 

If you want to calculate that as an average per product, you need to divide the total by the number of products sold. Let's say it was 2,295 products sold. 

11,000 / 12,295 = 4.79

So your net profit average per product is $4.79. 

What is a Net Profit Margin?

A net profit margin refers to the profit a business makes from its revenue. It's generally presented as a percentage. It can also be called the net profit margin ratio or just profit margin. 

This allows companies to understand how much profit they generate from their revenue. So if your net profit is 10%, that means for every $1 you sell, your profit is $0.10. 

To calculate net profit margin, you use a formula: 

Net Profit Margin = Net Profit / Total Revenue x 100 

So, for example, your company has a net profit of $68, but the revenue is $245. 

68 divided by 245 is 0.27. Multiply by 100, and your net profit margin is 27%. 

How To Improve Net Profit

There are plenty of ways to improve the net profit of your business so that you can earn more for every product you sell. It's all about ensuring you keep on top of all the direct costs involved with manufacturing your products and paying attention to the overheads and operating costs. 

Evaluate Products 

An excellent way to improve the company's profit is to examine all your products and determine which ones make you the least money. You should regularly calculate the net profit for each item in your catalog and remove any products or services that don't generate revenue. If the net income is low, you can evaluate whether or not that product is worth selling. 

Reduce Direct Costs

Looking at all the direct costs involved with running your business and making your products is an excellent way to improve overall net profit. You can always negotiate better rates with suppliers, vendors, or wholesalers to increase net profit. 

Even if it's a 10c difference per product, for every 1000 products sold, that's an additional $100. Say you sell 60,000 products annually. You've created an extra $6,000. So it's worth doing. 

Control Inventory

Managing your inventory effectively can help to increase overall net profit. If you apply inventory management techniques, you can ensure to order the correct amount of stock and reduce the likelihood of having additional stock that isn't going to sell sitting in your warehouse. 

Always make sure to have high-profit items available, so customers can buy them when they are looking for them. If you're running a sale, make sure there's enough stock of each item. 

Final Thoughts

We've taken you through all the essential financial terms and metrics for measuring your business. You should understand net profit and how to use net profit calculations to understand your company's financial health. 

They are essential metrics to include on the financial statements for your business too, and you can measure your company's profitability over time. It's also helpful to keep on top of your total expenses to include them when calculating your income tax with the IRS. You can do it yourself or pay someone to support you with your income taxes.

Net profit is an essential tool for understanding the profitability of each product you sell and should be used to influence your future business decisions.

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